Taxes Influence Investment Strategy, and Not Always for the Better

FOR years, many investors didn’t worry about the taxes they would pay on the gains in their investments until the bill arrived months later. But this year, with taxes higher, some investors have gone to the other extreme, choosing investments as much for their tax rates as for their risks and returns.

That may not be a good thing for their portfolios.

“Clients are definitely asking, because it’s a real issue in today’s environment,” Michael N. Bapis, a managing director and partner with the Bapis Group at HighTower Advisors, said. “We try to keep them focused on the goals — preserving what they have, capturing some of the upside, limiting the downside. At the end of the day, we can’t change the tax laws.”

When asked about how tax rates would affect an investment, he said his advice was almost always the same. “If it doesn’t make sense for your portfolio, then it doesn’t make sense,” he said, even if there is tax savings. “If it does make sense, regardless of the tax consequences, we’re going to put it in your portfolio.”

Last week, I looked at how the changes to the tax code were affecting how people thought about their estate plan. This week, I’m looking at how tax increases can influence people’s investing behavior.

The tax rates on investments have increased significantly from last year. Depending on a person’s income, taxes on long-term capital gains and dividends are now as high as 23.8 percent, an increase of 59 percent over last year’s rate. Taxes on investments that are held for less than a year that incur short-term capital gains tax or investments subject to income tax rates have increased for top earners by 24 percent, to 43.4 percent (with the Medicare surtax included) from 35 percent.

Those are substantial increases, but focusing on them alone can obscure a fuller analysis of risk. Investors can end up paying no taxes on an investment, but that may be because they lost money on it, or they may pay lots of taxes on a large gain that they might not have achieved otherwise. This is why advisers stress that taxes should not be the first concern when deciding whether to buy — or not buy — an investment.

If there is one investment that has been promoted as great for minimizing taxes and achieving a large gain, it is master limited partnerships. Most are involved in the transportation or storage of oil and natural gas. What makes them appealing, from a tax perspective, is that a large portion of the dividend they pay is treated as a return of principal and is not taxed.

But in the rush for one type of tax savings, investors can end up paying other taxes. Master limited partnerships with pipelines that run through several states can incur state tax bills for investors, though usually only when the income goes above a certain threshold.

The bigger tax concern generally comes when investors sell their partnerships, since the part of the dividend that was not taxed for years reduces the original price of the investment. Greg Reid, a managing director at Salient Partners and chief executive of the firm’s $18 billion master limited partnership business, said an investor who bought a partnership and sold it five to 10 years later could be faced with two types of taxes. The first is income tax, because the original purchase price would have been reduced by the amount of principal returned in the dividends. The second is capital gains tax on the increase in the value of the investment itself.

Another way to look at these partnerships is to consider the solid and increasing dividends they have paid over the last 25 years, often 6 to 7 percent.

“The baby boomers are going to need a lot of income to live,” Mr. Reid said. “M.L.P.’s are particularly great for older people who are retiring. They have a growing income stream.”

As for avoiding high taxes, the solution is to give the partnership to charity or die with it in your estate. Both may be viable options for investors in their 70s and 80s but are probably less attractive to people in their 30s.

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“At the end of the day, we can’t change the tax laws,” said Michael N. Bapis, a managing director and partner with the Bapis Group.Credit
Ozier Muhammad/The New York Times

Municipal bonds, which have long been attractive to wealthier investors because the interest they pay is not taxed by the federal government, pose a different sort of risk.

Mr. Bapis said he was concerned that investors who were not paying attention to the broader economic news were not aware of the current risks of buying an existing municipal bond. With yields on many municipal bonds extremely low — around 0.75 percent for five-year bonds and 1.74 percent for 10-year bonds, according to Bloomberg — even a small increase in their price, which would cause the yield to go down, would cause a loss of principal.

Mr. Bapis calculated that if the yield on the 10-year bond went to 3 percent, that could translate into a loss of 6 to 10 percent. The exception is if someone were to hold the bond until maturity. “But are you going to be able to stomach watching that bond go down 6 to 10 percent in the short term?” he asked.

On the other side of the tax equation are hedge funds, which as a group have fallen from their perch as exclusive vehicles that guaranteed high returns no matter what was happening in the world.

The tax-based argument against them is that funds that aggressively buy and sell securities generate a tremendous amount of short-term capital gains, and the higher taxes on those gains — double the long-term rate — erode the investor’s after-tax return. Since most hedge funds now have returns in the single digits — far-off their peak — along with high management fees and onerous clauses to keep investors from getting their money back or even knowing how it is invested, the higher investment tax could make hedge funds less attractive.

Yet the counterargument is that hedge funds can invest in ways that are not correlated with other markets and may have less volatility. If a hedge fund returns 9 percent before taxes versus 2 percent for a tax-free municipal bond, the hedge fund could be a better investment.

That higher return, known as alpha, against the market return, or beta, is what proponents of hedge funds push. “We’re happy to pay for that alpha as long as we get it,” said Jonathan Hill, investment strategist at Gibraltar Private Bank and Trust. “The worst-case scenario over the past few years is clients have paid for alpha and gotten beta.”

For most investors, though, there are simple strategies that they can use to manage taxes on any investment, and they can do so without tearing up their existing investment plan.

One of them is putting investments that generate higher taxes in tax-deferred accounts and those that generate lower or no taxes in regular brokerage accounts. “Asset allocation is even more important today,” said Eli Niepoky, chairwoman of the investment strategy group at Diversified Trust.

For example, she said, municipal bonds, stocks owned for a long time, and master limited partnerships should be held in taxable accounts, while investments that generate income or short-term capital gains should generally be put into tax-deferred accounts.

Another strategy that fell out of favor in the middle of the last decade but is returning is investing with an eye toward losses for tax purposes. Instead of investing in the S.& P. 500-stock index, a manager employing this strategy would invest in a smaller number of stocks in the index in an attempt to replicate the returns of the index. When a stock fell, say Pepsi, the manager would sell it and replace it with a similar one, like Coca-Cola.

“It’s definitely not an exciting topic,” said David Lyon, investment specialist at J. P. Morgan Private Bank. “Index replication is the ultimate goal, but if you can do it in a more tax advantageous way for the first four to five years than being in a pure index fund, that gives you more tax flexibility going forward.”

The downside, he said, was that your returns could reflect the index with little tax savings. But as long as the index went up, that’s not a bad trade-off.

A version of this article appears in print on May 4, 2013, on page B7 of the New York edition with the headline: Taxes Influence Investment Strategy, and Not Always for the Better. Order Reprints|Today's Paper|Subscribe